How does the government use spending and taxation to manage the economy?
What fiscal policy is, how changes in government spending and taxation affect growth, employment and prices, and the costs and benefits of using it.
An OCR J205 answer on fiscal policy: how government spending and taxation are used to pursue economic objectives, their effect on growth, employment and inflation, and the trade-offs involved.
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What this dot point is asking
OCR wants you to explain what fiscal policy is, how changes in government spending and taxation affect growth, employment and prices, and the costs and benefits of using it. Fiscal policy is one of the government's three main tools for managing the economy.
What fiscal policy is
The government's budget is the balance between its spending and its tax revenue. A budget deficit is when spending exceeds tax revenue (the government borrows); a budget surplus is when tax revenue exceeds spending.
Expansionary and contractionary fiscal policy
The chain of reasoning for expansionary policy is: lower taxes or higher spending raise households' and firms' spending power, so total demand rises, so firms produce more and hire more workers, raising growth and employment. Contractionary policy works in reverse.
Effects on the objectives
Fiscal policy affects all the macroeconomic objectives, often with trade-offs:
- Growth and employment. Expansionary policy raises both; contractionary policy can slow them.
- Inflation. Expansionary policy can raise inflation, especially if the economy is near full capacity; contractionary policy helps control it.
- Distribution. The choice of which taxes to change and what to spend on affects inequality (for example, progressive taxes and benefits reduce it).
Costs and benefits
Fiscal policy is powerful but has drawbacks:
- Government borrowing. Expansionary policy often means a larger budget deficit and rising national debt, with interest to pay.
- Opportunity cost. Money spent one way cannot be spent another; tax cuts mean less revenue for services.
- Time lags. It takes time to plan and deliver spending, so the effect may come too late.
- Inflation risk. If demand rises faster than the economy can produce, the result is inflation, not more output.
Try this
Q1. Define fiscal policy. [2 marks]
- Cue. The use of government spending and taxation to influence the economy.
Q2. Explain one way contractionary fiscal policy could reduce inflation. [3 marks]
- Cue. Raising taxes or cutting spending lowers total demand, so demand-pull pressure on prices eases and inflation falls.
Exam-style practice questions
Practice questions written in the style of OCR exam questions on this dot point, with worked answer explainers. The year tag is the paper they imitate, not the source.
OCR J205/02 20194 marksExplain how a government could use fiscal policy to reduce unemployment in a recession.Show worked answer →
A 4 mark Explain question on expansionary fiscal policy.
In a recession the government can use expansionary fiscal policy: increase government spending (for example on infrastructure) and/or cut taxes (such as income tax). This raises total demand in the economy.
Higher demand means firms produce more and hire more workers, so unemployment falls. Markers reward identifying expansionary fiscal policy (more spending or lower taxes), the rise in demand, and the fall in unemployment as firms expand.
OCR J205/02 20226 marksDiscuss the costs and benefits of a government raising spending to boost the economy.Show worked answer →
A 6 mark evaluative question.
Benefits: higher spending raises demand, output and employment, can fund useful infrastructure that raises long-run productivity, and helps the economy recover from recession.
Costs: the spending must be paid for, so it may mean higher borrowing (more government debt and interest) or higher taxes later; there is an opportunity cost (the money could fund something else); and if the economy is already near full capacity, extra demand mainly causes inflation rather than more output. Markers reward both sides and a judgement, for example that boosting spending helps in a recession but risks debt and inflation if overused.
Related dot points
- What monetary policy is, how the central bank uses interest rates to affect saving, borrowing, spending and investment, and the effects on growth and inflation.
An OCR J205 answer on monetary policy: how the Bank of England uses interest rates to affect saving, borrowing, spending and investment, and the effects on growth and inflation, with interest calculations.
- What supply-side policy is, the main supply-side measures (education, training, infrastructure, incentives), and how they raise productivity and long-run growth.
An OCR J205 answer on supply-side policy: how measures such as education, training, infrastructure and incentives raise productivity and the economy's long-run productive capacity.
- The types of tax (direct and indirect, progressive and regressive), the main areas of government spending, and the purposes of taxation.
An OCR J205 answer on taxation and government spending: direct versus indirect taxes, progressive versus regressive taxes, the main areas of public spending, and why governments tax.
- The government's main economic objectives (growth, low unemployment, price stability and a fair distribution of income), and why they can conflict.
An OCR J205 answer on the government's main macroeconomic objectives (economic growth, low unemployment, price stability and a fair distribution of income) and the trade-offs between them.
- The meaning and measurement of unemployment, the main types and causes of unemployment, and the consequences of unemployment for individuals, firms and the government.
An OCR J205 answer on unemployment: how it is defined and measured, the main types and causes, and the consequences for individuals, firms and the government.
Sources & how we know this
- OCR GCSE (9-1) Economics J205 specification — OCR (2017)